What are the Benefits of Non-Recourse Loans?
One of the biggest benefits of HUD 221(d)(4) loans for developers is the fact that they are non-recourse-- i.e., the lender cannot seize a borrower's personal property if they default on the loan. Instead, HUD multifamily construction loans are secured by collateral; in this case, the building and the property itself, which can be seized if the borrower defaults.
Non-Recourse Loans: The Basics
One of the biggest benefits of HUD 221(d)(4) loans for developers is the fact that they are non-recourse. This means the lender cannot seize a borrower's personal property if they default on the loan. Instead, HUD multifamily construction loans are secured by collateral. In this case, the collateral is the building and the property itself, which can be seized if the borrower defaults. In contrast, full-recourse loans require the borrower (or certain principals) to sign a personal guarantee (PG), making them legally and personally liable for the debt should they default.
Non-Recourse Loans are Still Usually Subject to "Bad Boy" Carve-Outs
While it's true that FHA multifamily construction loans are non-recourse, there can be some exceptions. In most cases, certain principals will still be required to sign "bad boy" carve-outs. These are documents that stipulate that they will be held personally liable for the loan in the case of egregious misbehavior (usually fraud or serious misrepresentation of their financial situation). Despite that, some lenders have a much lower standard than others when it comes to what constitutes being a "bad boy." Because of this, it is essential to read and analyze all the terms of a potential loan before signing anything.
Benefits of Non-Recourse Loans
The primary benefit of non-recourse loans is that they provide a greater degree of protection for the borrower. Without a personal guarantee, the lender cannot seize the borrower's personal assets if they default on the loan. This can be especially beneficial for developers who are just starting out and don't have a lot of assets to protect.
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What are the advantages of non-recourse loans for commercial real estate?
Non-recourse loans offer investors the security of not having to repay any of their personal capital should the property they invested in become unsuccessful. The only loss would be the property itself, as that is used as the collateral. This can be a great option for investors who are comfortable with riskier investment plays, as it eliminates the need to worry about being personally on the hook for losses if something goes wrong.
The main advantage of a non-recourse loan for borrowers is the lack of any personal liability. If a loan defaults, the borrower can effectively walk away, after all.
Another advantage of a non-recourse loan is that it can enable an investor to borrow more. This is because the debt isn’t tied to the borrower’s income or total assets — as they aren’t involved in non-recourse financing. With recourse debt, banks and other lenders can place a cap on how much debt they can accept, relative to an investor’s personal income.
Finally, non-recourse loans can be significantly less complicated for a syndication or partnership. Consider the challenges of recourse financing in such a situation: Let’s say three investors pool their resources to finance the acquisition of a shopping center. Which of the three should be willing to put their personal finances on the hook, should the investment go south? Would you do it?
What are the risks associated with non-recourse loans?
The main risks associated with non-recourse loans are tied to the loan terms a borrower can receive. Because the risks to a lender are higher than with recourse debt, a lender will typically pass this on in the form of higher interest rates, or lower loan amounts relative to the property value to offset the risk. This typically makes non-recourse financing more expensive.
Another potential risk is tied to exceptions to the non-recourse clause in the loan. While it’s true that a lender generally cannot pursue a borrower’s personal assets or income outside of the property itself, most non-recourse loans include language for what are known as bad boy carve-outs. These provisions essentially state that, should the borrower misrepresent a property or themselves, or file fraudulent financial documents — like tax returns or financial statements — the borrower is no longer protected by the non-recourse clause and is fully responsible for the loan. They may also cover other acts, such as raising subordinate financing when it’s not allowed, or even paying real estate taxes late.
What types of commercial real estate projects are eligible for non-recourse loans?
Non-recourse loans are typically available for Class A office or multifamily properties in major MSAs (i.e. New York or Los Angeles). Class B retail properties in tertiary markets are unlikely to qualify. Property income (both past and present) is also a determining factor, as well as the requested amount of leverage.
What are the requirements for obtaining a non-recourse loan?
In order to qualify for a non-recourse loan, commercial lenders often have strict eligibility requirements. Most non-recourse programs can only be utilized for the financing of certain property types and classes, such as class A office or multifamily properties in major MSAs (i.e. New York or Los Angeles). The income that a commercial property produces (both past and present) is also a determining factor. Additionally, lenders tend to analyze the requested amount of leverage. Non-recourse commercial mortgage loans tend to have higher interest rates than their recourse counterparts, and are also generally only available to borrowers that have a very strong financial profile. Lenders can be pretty strict about this, the thought process being that a default is significantly less likely in this scenario because the borrower has the financial means to make sure that the property’s income is reinvested into the property. Aside from strong finances, commercial mortgage lenders also require a very experienced borrower with ample "skin in the game" for non-recourse financing.
How do non-recourse loans differ from recourse loans?
Non-recourse loans differ from recourse loans in that recourse loans require the personal guarantee of the borrower(s) so that in the event of loan default if the bank doesn't recoup their full investment from selling the property, the borrower and their personal assets are on the line for the remainder of the funds to make the bank whole. In the case of non-recourse commercial loans, the bank’s only way to recoup lost investment and yield in the event of a default is through the property itself and the income the property generates.
Because of the difference in risk to borrowers and lenders, there are some key differences in loan terms and requirements. In brief:
Recourse Loan Nonrecourse Loan Risk Profile Riskier for borrowers Riskier for lenders Default Event Lenders may pursue a borrower's personal assets Lenders may generally only pursue a loan's collateral. Borrower Profile Typically less experienced More experienced, financially stronger Interest Rate Generally lower Generally higher Asset Types Any Often restricted to "strong" assets and locations LTV Generally higher Generally lower Examples Most bank loans, bridge loans, construction loans Most Fannie Mae®, Freddie Mac®, CMBS loans
While borrowers broadly prefer nonrecourse financing, lenders favor recourse loans due to lower risks. Due to this imbalance, these types of loans tend to have rather different terms associated with them.
What are the tax implications of non-recourse loans?
The tax implications of non-recourse loans depend on the type of loan and the borrower's individual situation. Generally, the interest paid on a non-recourse loan is tax-deductible, just like with a recourse loan. However, the borrower may not be able to deduct the full amount of the interest if the loan is considered a "qualified mortgage" under the Tax Reform Act of 1986. In this case, the borrower may only be able to deduct the interest on the loan up to the fair market value of the property. Additionally, the borrower may be subject to capital gains taxes if the loan is used to purchase an investment property.
For more information on the tax implications of non-recourse loans, please consult a qualified tax professional.